LeapFrog 2012 Annual Report Download - page 53

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LEAPFROG ENTERPRISES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except per share data)
limited to: macroeconomic conditions, industry and market considerations, cost factors, overall financial
performance, LeapFrog-specific events and share price trends. Additional judgment is required to determine
relative importance and impact of each factor.
Application of the two-step goodwill impairment test, if determined necessary, requires significant judgment,
including identification of reporting units, assignment of assets and liabilities to reporting units, assignment of
goodwill to reporting units, determination of the fair value of each reporting unit, and projections of future net
cash flows, which are inherently uncertain. The fair value of each reporting unit is estimated using a
combination of a market approach and a discounted cash flow methodology. The market approach requires
considerable judgment in selecting comparable companies and estimating the multiples of revenue implied by
their market values. The discounted cash flow methodology requires management to exercise judgment in
selecting an appropriate discount rate and to make numerous assumptions in order to develop future business
and financial forecasts and the related estimates of future net cash flows. Future net cash flows depend
primarily on future sales of the Company’s products, which are inherently difficult to predict. This is
especially true when a significant portion of the Company’s future net sales is expected to be generated by
both mature products as well as products introduced in 2012 or planned to be introduced in 2013.
Research and Development Costs
Internal and external research and development costs incurred before a project reaches technological feasibility
are expensed as incurred. External costs incurred after a project reaches technological feasibility are
capitalized. Capitalized costs are amortized into cost of sales when the product is released to the market,
generally over two years using the straight-line method. Capitalized research and development costs are
periodically reviewed for future recoverability. Impairment losses are charged to cost of sales in the period in
which they occur.
Advertising Expense
Production costs of commercials and programming are expensed when the production is first aired. The
Company’s direct costs of advertising, in-store displays and promotion programs are expensed as incurred.
Under arrangements with certain of its customers, the Company reduces the net selling price of its products as
an incentive (sales allowance) for the customers to independently promote LeapFrog products for resale. If the
benefits LeapFrog receives from the customer in these cooperative sales or advertising arrangements are not
specifically identifiable, the Company recognizes the costs as a direct reduction of revenue earned from the
customer during the period, with a corresponding reduction in accounts receivable. In those cases where the
benefits received from the customer are sufficiently separable and can be specifically identified, these costs are
included as advertising expense during the fiscal period in which the promotions are run.
Royalty Expense
The Company licenses certain of its content from third parties under exclusive and nonexclusive agreements,
which permit the Company to utilize characters, stories, music, illustrations and trade names throughout
specified geographic territories. Royalty payments are typically calculated as a percentage of the unit product
selling price. Royalty expense is recorded when products are shipped to a customer or upon delivery of
content via the App Center, and it is reported under cost of sales in the statements of operations.
Derivative Financial Instruments
The Company transacts business in various foreign currencies, primarily in the British Pound, Canadian
Dollar, Euro and Mexican Peso. As a safeguard against financial exposure from potential adverse changes in
currency exchange rates, the Company engages in a foreign exchange hedging program. The program utilizes
foreign exchange forward contracts that generally settle within 30 days to enter into fair value hedges of
foreign currency exposures of underlying non-functional currency assets and liabilities that are subject to
remeasurement. The exposures are generated primarily through intercompany sales in foreign currencies and
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